Friday, November 22, 2013

Countercyclicality, Countermajoritarianism, and Central Bank Mandates

By Bob Hockett

In a characteristically thought-provoking post on the Fed’s
monetary easing policies earlier this week, Professor Dorf suggests that in a
certain sense, the wisdom with which Chairman Bernanke’s Fed has managed
post-crisis credit and liquidity conditions is a fortunate accident – one that
we might not, strictly speaking, have earned through legislation.There are two mutually complementary
reasons. First, what many take for the traditional
anti-inflationary rationale behind central bank independence (as manifest both
in the term structure of Fed Board appointments and in the Fed’s substantive
mandate) is not implicated in the current credit environment.And second, there is no inherent, structural
reason to expect politicians to be biased toward tight money policies as there
is to expect them to be biased toward loose money policies, hence no reason to
suppose that the Federal Reserve Act’s framers meant to insulate the Fed from
politics – that is, to render it more or less independent – for any reason other
than inflation-prevention.As Professor
Dorf points out, the two reasons jointly suggest that the Fed’s now filling-in
for a derelict Congress by using expansionary monetary policy as a substitute
for missing fiscal policy is more happy accident than it is anything that we as
a polity have acted through White House and Congress to assure.

It seems to
me that Professor Dorf is quite right, but it might be helpful nevertheless to
add a few supplementary observations concerning the evolution of central bank
theory, practice, and legislation in recent decades.For if what I’m about to report is correct,
then there is at least one important sense in which current Fed policies, evenin the very forms they’re now taking,
can be said in effect to have been legislated – or at the very least
legislatively ratified.

Here’s what I
mean, proceeding in order from theory, to practice, to legislation.

First as a matter of theory, the traditional ‘sound
money,’ anti-inflationary rationale for central bank independence can be, and
has indeed long been in the process of being, generalized and refined along two
dimensions.The generalization and
refinement begin by noting that inflation has a contrary – deflation – which is
just as apt to occur over time as inflation.Indeed there are structural reasons, to which I’ll return, for expecting
so, and these are even deeper seated than are the structural reasons of which we
typically think when we think of the anti-inflation mandate alone.The generalization and refinement then
conclude by recognizing that inflation and deflation – and, indeed,
hyperinflation and hyperdeflation – can and do tend to occur in more than just
consumer goods and services markets.They happen in financial markets as well.Indeed a financial asset price bubble just is
a species of hyperinflation, and a bubble-following bust is symmetrically an asset price
hyperdeflation, as argued here.

Now, asset
price inflations and deflations, via the so-called ‘the wealth effect,’
sometimes spill into the real economy to induce counterpart consumer price
inflations and deflations – often with devastating effect.Frequently, in fact, the latter bring on what
the great American economist Irving Fisher dubbed ‘debt-deflations.’They do so any time that the antecedent asset
price bubble has been significantly fueled – as most if not all of the worst of
them are – by cheap credit, in a manner that incents even rational market
participants to ‘leg’ the proverbial ‘spread’ between low borrowing costs and
high capital gains appreciation rates.When variable prices of the latter sort ultimately drop in the bust, and
the fixed debt obligations incurred in financing the speculative asset purchases
do not, victims are left with potentially crippling private debt overhang.Growth- and employment-underwriting consumer
expenditure in consequence takes a significant hit, and protracted slump is the
end product.Such is the substance of
Fisher’s regrettably forgotten ‘debt deflation theory of great depressions.’

So what does this have to do with central banking
theory?The key point, in my view, is
that asset price hyperinflations and debt deflations are what I call ‘recursive collective action problems.’In a
classic collective action problem, multiple individually rational actions
aggregate into a collectively damaging outcome.Such problems take on recursive properties when the rational actions in
question are rational responses to antecedent actions of the same type.Where the recursive element is present, a
collectively ‘damaging’ outcome can become downright calamitous.For recursive processes lack tolerable stable
equilibria; things either grow worse and worse or they settle into unbearable
patterns – as that other celebrated
20th economist, J. M. Keynes, in effect noted when diagnosing what he
dubbed ‘liquidity traps’ and ‘paradoxes of thrift.’

Now once attention has been called to it, it is easy
to see the structure just outlined at work in any inflation or deflation –
including those that afflict financial markets and broader macroeconomies.While prices are rising and credit remains
virtually limitless and cheap as it did for much of the late 1990s and early
2000s, it is financially rational for market actors to borrow and buy, then to
borrow and buy more as previous iterations of the process drive prices yet
higher without correspondingly raising the cost of credit.Subsequently, when confidence in the
soundness of assets evaporates and the ‘run’ or the ‘fire sale’ begins, it is
symmetrically rational for market actors to rush to avoid being last out the
door.There is nothing that any one
market participant can do to arrest the upswing or downswing, after all, so her
best response is simply to join in the race and work hard not to lose.But the rationality of each in these settings
is the futility of all.

Recursive collective action problems of this sort, as I’ve argued elsewhere, are pervasive in financial markets and
macroeconomies.What can – what do – we
do about them?To solve a collective
action problem requires a collective agent – some agent able to act in the name
of all.That agent must act as to render
no longer rational such decisions as, when aggregated, bring on the calamitous
outcome.In the case of an asset price
hyperinflation, that is done by closing the spread between low borrowing costs
and high capital appreciation rates – that is, by raising borrowing costs,
taxing away capital gains at increasing rates, or both.In the case of a corresponding asset price
hyperdeflation and ensuing debt deflation, the collective agent symmetrically
does the contrary.It acts to lower
borrowing costs, stimulate asset price growth, or both.In extreme cases, it must act to pare down
private debt too – either directly, by facilitating loan modifications or
bankruptcy cramdowns, or indirectly, by pumping up asset prices and thereby
trimming the relative reach of the private debt
overhang.

Now if we look at the evolution of central bank
practice over the past century or so, I think we can spot what amounts to an
implicit recognition on the part of central bankers that they are the requisite
‘collective agents’ upon whom I have just called.On the upswing side of the business or credit
cycle, central banks have long acted to counter consumer price inflation, of
course, but now have begun looking for ways to curb financial asset price
hyperinflation as well.The old ‘lean versus clean’ debate that used to divide American central bankers from their
counterparts at the Bank for International Settlements in Basle, in other words,
appears at last to have been won by the ‘leaners’ – those who, like Fed Chairman
Martin nearly five decades ago, view the job of the central bank as that of
‘leaning against the wind.’You’ll find
evidence of the shift every time you read or hear the words ‘macroprudential
regulation’ or ‘systemic risk regulation’ in connection with the word
‘financial.’The name of the game now is
to preempt financial asset price hyperinflations before they commence, just as
it’s long been to act similarly in respect of gathering consumer price inflations.You can read more about these developments
here and here, in two papers stemming from work I have done for the New York Fed
and the International Monetary Fund in recent years.

On the downswing sides of the business and credit
cycles, central bankers have also long acted to counter consumer – and asset –
price deflation.Indeed that’s precisely what ‘cleaning’
refers to when one speaks of ‘leaning or cleaning.’Walter Bagehot famously called attention to
the cleaning role, under the now canonical ‘lender of last resort’ rubric, back
in the late 19th century.And
even Fed Chairman Greenspan believed in an energetic ‘cleaning’ role, his having
pursued it a bit overzealously post 9/11 being thought by many to have played a
critical role in fueling our recent housing price bubble.The best way to view what Chariman Bernanke’s
Fed has been doing since 2008 – and what its Japanese counterpart has been doing
even longer and its European counterpart is beginning to do now – is,
accordingly, as a simple and straightforward intensification of what central
banks long have done after busts.From
easing credit and monetary conditions through commercial paper or treasury
security purchases as was done in the 19th and 20th
centuries, respectively, central banks are now moving toward easing conditions
yet further – and propping up particular asset class prices in particular
wealth-effect-salient markets like housing – by purchasing additional classes of
financial asset like mortgage backed securities.I for my part have proposed yet more incremental, fine-tuning extensions of the Fed-as-market-actor role in the name
of credit-modulation.

So have we actually legislated this still evolving
collective agential role for our central bank?Is the Fed statutorily authorized to act as a collective agent of the
kind I’ve described?In two mutually
complementary senses, I think that it is.To see why, note first this
entailment of the central bank’s role as I have just sketched it: the
‘collective’ agent that I am describing is a countercyclical agent.The central bank’s role is to buck trends and
act contrary to deeply rooted, otherwise inescapable business and credit
cycles.It is to be cyclically
contrarian.It’s to act bearishly during
bullish times, and to act bullishly during bearish times.It’s meant to steer us clear of, or bump us
out of, intolerable equilibria – underspending, underemployment equilibria
during busts and ensuing debt deflations, and overspending, overborrowing
equilibria during inflations.

But now note this further entailment of my
characterization of the central bank’s role: the countercyclical agent must by definition
be a countermajoritarian agent.That which fuels cyclical movement, after
all, is majoritarian action – aggregated individually rational actions.For the good of all, then, the central bank must
act contrary to all, precisely
because its bailiwick – the financial, monetary, and macro- economies – is
structurally susceptible to recursive collective action problems per which each
person’s acting rationally is all people’s acting self-defeatingly.In this sense, the case for a
countermajoritarian central bank might be even stronger than that for
countermajoritarian courts.After all,
crowds seem merely susceptible to
‘rushes to judgment’ on various matters, but seem downright doomed by the structure of reciprocal
action itself to financial hence macroeconomic boom and bust cycling.So have we legislated this – the central bank’s institutional
contrarian role?Have we deliberately
conferred a countermajoritarian function upon the Fed in the way that we have on
the federal courts – by insulating its key personnel from political pressure and
by formulating its mandate in sufficiently capacious terms?I think that we have – both implicitly and,
to a degree, even explicitly.

Note first that the Fed’s enabling legislation charges
it with acting to maintain both ‘stable prices’ and ‘maximum employment.’What do those phrases mean?Well, long before these two sides of the
so-called ‘dual mandate’ had both found their way into the Fed’s enabling act,
economists, policy analysts, and members of Congress alike had come to
understand that stable prices are maintained by tightening credit and monetary
conditions in the face of inflationary pressures, and loosening the same in the
face of deflationary pressures.They
also understood that ‘maximum employment,’ at least as a central bank mandate,
is pursued through the same aforementioned loosening of credit and monetary
conditions, and that ‘going too far’ in this direction could under some
conditions imperil the successful execution of the price-stability-maintenance
function.

The Fed has in consequence viewed its role for decades
as maintaining a balance between maximum sustainable employment on the one hand,
price stability on the other hand.It
has acted, in other words, to arrest declining employment so as to prevent its
morphing into indefinite underemployment equilibrium on the one hand, and to
arrest increasing prices so as to prevent their morphing into consumer price
hyperinflations on the other hand.This
was the case well before the current wording of the mandate was formulated in
the late 1970s, and the latter can accordingly be viewed, along with the
enhancing of Fed independence during the 1950s and its continuation ever since,
as implicit Congressional ratification of the Fed’s gradually developing
countercyclical, hence countermajoritarian, role.

But wait, you
might say.Given that ‘stable prices’
used to be taken, in effect, to allude only to consumer price inflation, can we
plausibly take that phrase to embrace debt deflations and financial asset price
bubbles and busts too?I don’t see why
not.Since only the word ‘prices,’ not
the word ‘inflation’ or the phrase ‘consumer prices’ is used, and since it has
always been understood that there is at least some relation between the financial and
‘real’ economies such as enables dysfunction in the former to spill into the
latter, it would seem that the Fed’s – along with other central banks’ –
gradually coming to appreciate that financial markets are as prone to
destructive yet modulatable cycling as are consumer goods and services markets
was foreseeable enough by those who introduced the ‘stable price’ and ‘maximum
employment’ mandates, and presumably embraced accordingly by Congress.Why not, then, read the Federal Reserve Act
as both (a) ratifying developments that had occurred in central bank practice as
informed by developing theory by 1977 when the Act was amended, and (b)
embracing developments that occur along that same trajectory since then?

6 comments:

A further thought: In the current moment we are seeing no inflationary pressure on consumer prices but are experiencing asset price inflation. The Dow hit 16k for the first time ever today. This combination puts the Fed in a bit of a pickle. For the health of the real economy, it should keep its foot on the gas, but to let some air out of the asset price bubble it should take away the punch bowl. (How's that for a mixed metaphor?!) But the Fed obviously can't do both simultaneously, which perhaps shows why monetary policy alone is a poor substitute for monetary policy coupled with fiscal policy.

Very important point, Mike - thanks. I think that in future we'll see more fine-tuning where credit-cum-monetary policy is concerned, particularly if fiscal policy continues essentially non-existent as it's been in recent years. In the 2011 Benzinga column that I link to above via the phrase 'fine-tuning,' I proposed Fed shorting of commodities to dampen QE's regressive effects as in food, fuel, and other commodity price inflation. And in the 2013 Theoretical Inquiries in Law piece, co-authored with Professor Omarova, linked to via the phrase 'market-actor' above, Professor Omarova and I advocate consideration of additional such market interventions - including labor market interventions in the guise of an 'employer of last resort' function - to affect wage and employment rates. It might be that margin requirements in the commodity case would be better than shorting, but the essential idea would be the same: Chairman Bernanke's innovations are only the tip of the proverbial iceberg where monetary policy's substituting for fiscal policy is concerned. Once we recognize that ALL monetary policy is inherently distributive (e.g., tight money favors rentiers, inflation favors debtors), there seems little reason to let taboos against 'credit-allocation' prevent our mimicking fiscal policy across the board with monetary policy. Central banking has occasionally been called the last refuge of central planning. Count me guilty as charged. :)

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